Sustaining The Surge Of Venture Capital Funding

In the US, venture capital (VC) funding has reached its highest point since the dot com era. Initially, this sounds like a positive thing. In fact, it’s been argued that there’s never been a better time to be an entrepreneur. However, this influx in funding has mainly filled the pockets of bigger investors. This is due to the fact that major funds wait until the later stages of investment to pick out the companies with the highest potential to generate returns. According to ex VC investment partner Martyn Holman, European VC is experiencing a similar wave. How can funds sustain this growth, what trends are characterising the market, and what impact will disruptive technology have on VC investment?

Concentrated investment

While the US and European VC ecosystems are certainly demonstrating health, Holman explains that there is a concentration of returns in European VC that might lead to longer term changes in the industry.

“Fund maths dictates that to target a 3x return on a fund, a VC fund needs to have a fund returner. If you think about a decent sized series A fund, generally at the $50 – 100m size, a fund returner is generally going to need to exit at a valuation north of half a billion. In Europe, there are max 10 to 15 exits of that magnitude per year out of a total of about 300 VC backed exits. Top tier investment funds, particularly at Series A and beyond, have a monopoly on that deal flow because of their resources, network reach and influence.”

“80 per cent of the value returned to VC investors in recent times has been from those large (over half a billion) exits. This means that the top tier funds that are monopolising these deals at Series A and beyond (when traction becomes easier to spot) are generating super returns in excess of 3x. Given the overall industry returns of 2.5 to 3x, this means that other firms fighting over the remaining 20 per cent are struggling to return their capital. In an attempt to address this issue, there has been a movement of capital to the earlier stages – pushing up failure rates and valuations, which have doubled at seed stage over the last five years.”

In other words, for non top tier funds, it’s a vicious circle. They try to identify big wins by investing at an earlier stage, which inevitably bumps up failure rates. So what can they do to change it?

“The first thing is to get preferential access ahead of big network funds. How do you get into those deals? Maybe through a technology cluster,” explains Holman. “The second way is to be doing something fully disruptive in VC. You see lots of funds that are trying to be different. The third thing is to fundamentally change the failure rates. Fund maths dictates that you need to be chasing a fund returner. If you can affect the failure rate, you don’t necessarily need to chase a returner, although this is somewhat the holy grail for early stage investing! We will also need more big exits or more opportunities for more funds to be investing in companies that return large amounts.”

Tracking trends

Given the rise in valuations and mass funding, you’d be forgiven for wondering if the VC market is experiencing an unsustainable boom. Holman, however, is unconvinced. Instead, notwithstanding the corrections that will inevitably arise from the recent movement to earlier stages, he believes that the asset class is healthy overall, driving the development of communities, increased capital, network growth and talent. The challenge, however, will be finding an equilibrium in the face of unequal returns, which will have a fundamental impact on early stage investment. VCs need to invest in companies that have the potential to reach $100m revenue without taking an outside market share. Generally, therefore, it appears that VCs herd around major themes. At the moment, these themes include AI, blockchain, AR and VR. Over the next five years, Holman expects that disruptive technology will play a major role not just in what funds they choose to invest in, but also in how they invest.

“I think you’re going to see an increase of technology in the deployment of investment, not just as something that is invested in. You see that already with funds like InReach Ventures that use AI to identify deal flow. It’s about getting advantaged access. I think you’ll definitely see AI and data technology coming into the VC space.”

The power of policy

As always, politics has a role to play in the development of the market. How will governing bodies, both national and multinational, contribute to European investment funds?

“There are obvious questions about European funding in the UK. There is uncertainty around the willingness of the European Investment Fund to invest in UK VC funds in the wake of the Brexit vote. Government funds generally cornerstone a new fund, particularly where the managers are new or raising a first time fund, so that other investors have the confidence that the fund will close and are more likely to signal their commitments. They play an invaluable role,” says Holman. Last year, for example, the government responded to uncertainty over the European Investment Fund (EIF) by committing to plug the expected funding gap via the British Business Bank which supports UK investment funds.

Another theme is the emergence of non traditional investors. New behemoths like Softbank’s Vision Fund, for example, can stand their own against traditional VC funds. For the most part, though, the nature of competition depends on what stage a fund invests at. At later stages, Holman explains that funds collaborate to share risk and pool different points of view.

“It’s generally a healthy thing to have,” he says, “I don’t see it as a threat – I see it as an extension of the environment.”

As healthy as the US and European venture capital investment scene appears, it’s important to recognise that it’s not good news for everyone. Less influential and earlier stage funds need to find ways to maximise the potential of their investments, or face considerable losses. There will always need to be adjustment in the face of current imbalances. Applying disruptive technology to the VC investment process could be instrumental in identifying important trends – which, ironically, may be disruptive tech itself. But tracking trends can only go so far, and their impact remains uncertain.
“In essence, VCs are investing in very risky assets,” says Holman. “Nobody’s got a crystal ball.”

What other strategies could funds use to break the cycle of early investment and high failure? Will the VC investment market experience a boom? Will innovative technology like AI be available to smaller, earlier stage funds as well as major investors? Comment below with your thoughts.

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